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Carrots, Sticks, and CEOs

That $500,000 compensation cap makes even more sense than you think.

By now you've probably heard about the proposed $500,000 compensation cap for bigwigs at companies that are receiving "extraordinary" government bailouts. (Bonuses will also be prohibited, it seems, though normal stock dividends are OK.)

I suspect that most of us clapped our hands in glee about this. After all, most of us are sickened at the outrageous compensation packages so many CEOs are getting these days, even when they don't seem to be performing particularly impressively. A CEO himself, Fool co-founder Tom Gardner is disgusted with Wall Street in general, and has even suggested firing hundreds of executives.

It's not hard to look at companies with terrible performances and find CEOs taking home millions. Tenet Healthcare's (NYSE:THC) Trevor Fetter, for instance, received more than $10.5 million in 2007, according to the company's proxy filings. The company's stock fell 27% in 2007, and 77% in 2008. A few months ago, the proxy-advisory firm Glass, Lewis released a report that evaluated CEOs on the basis of performance and compared their pay to peers. Here are a few examples of overpaid and underpaid CEOs from the report:

Most overpaid:

Sprint-Nextel(NYSE:S)

KB Home(NYSE:KBH)

Jones Apparel(NYSE:JNY)

Most underpaid:

Apple(NASDAQ:AAPL)

MEMC Electronic Materials(NYSE:WFR)

Leucadia National(NYSE:LUK)

While capping pay for those needing a bailout seems reasonable to me, I confess to being uncomfortable with suggestions of widespread CEO salary-slashing. That's because some CEOs, while enjoying generous compensation, still serve their companies well, by leading them to even more generous profits.

My colleague Anders Bylund has suggested that companies' profits can benefit when CEO salaries are kept in check, and the above list sure seems to support that. (I recently offered up a new way to reduce CEO salaries -- suggesting auctioning off the jobs.)

Incentive is criticalOne point about the restriction that I do like is its impact on incentives. Economics professor Tyler Cowen has noted that the limit could succeed in "keeping the bailout plan affordable" by encouraging some executives not to participate.

Certainly, if executives don't have any restrictions on taking bailout money, they'll have plenty of incentive to take as much as they can. That will make the bailout overall much more expensive. On the other hand, with the restrictions, executives won't want to participate and give up lofty salaries unless they absolutely have to.

All this relates to the general idea of how you compensate executives. If you pay in stock options with terms that encourage positive stock performance, then executives will have every incentive to increase share prices, for the mutual benefit of both themselves and shareholders. On the other hand, if companies put together lavish pay packages that include things like big no-fault severance payments, executives know they'll end up well-off no matter what, reducing their incentive to work to maximize share value.

What to doAll of us should consider the incentives we have to do things. In our family lives, we might ask ourselves what incentives we've set up to help our children do more of this or less of that. At our jobs, we might check to make sure that those who work with us have the right motivation to perform well.

In our investing, we might take a close look at how the companies whose shares we own compensate their executives. If management's incentives are aligned with shareholders (i.e., they hold company stock just like we do), that's a reason to buy, while huge golden parachutes might lead you to avoid some stocks.

Incentives can make a big difference, so be sure to keep your own investing incentive in mind as you manage your money.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian